Transcript 2-Day Course on Islamic Banking and Capital Market

2-DAY COURSE ON
ISLAMIC BANKING AND CAPITAL
MARKET: PRODUCTS & INSTRUMENTS
22 -23 MAY 2007
Accounting, Auditing and
Governance
for Islamic Financial Services
Dr. Syed Musa Alhabshi
Principal Consultant
Amanie Business Solutions Sdn Bhd
Suite A-D, 14th Floor, Bangunan Angkasa Raya
Jalan Ampang, 50450 Kuala Lumpur
Tel: +603 2034 2545
Fax: +603 2034 2546
http://www.amanie.com.my
PRESENTATION OUTLINE


Nature of Islamic Financial Institution (IFI)
Financial Reporting Framework for IFI

Nature and Reporting Process of IFI

Shariah Governance & Auditing of IFI

Governance for IFI




Accounting and auditing standards for Islamic financial
institutions (AAOIFI, MASB, IFSB etc.)
Risk management
Shariah review and audit
Issues and challenges
FINANCIAL REPORTING
FRAMEWORK
USER
GROUPS
SHARI’AH
PRINCIPLES
ISLAMIC
FINANCIAL
INSTITUTION
FINANCIAL
REPORTING
OBJECTIVES
ACCOUNTING
PRINCIPLES
THE NEED FOR SPECIFIC ACCOUNTING
STANDARDS IN ISLAMIC BANKING



The fast development of Islamic banking demands
for effective financial reporting framework and
information disclosures useful for investors and
stakeholders.
Existing financial reporting standards for
conventional financial institutions are not
adequate to address the information needs of
IIIFS.
Nature of Islamic banking emphasizes importance
of lawful and equitable banking business and
financial activities - accounting treatments that
capture unique features of IIFS activities are
required
ESTABLISHMENT OF AAOIFI


The Accounting and Auditing Organization for
Islamic Financial Institutions (hereinafter
referred to as AAOIFI) is an Islamic
international autonomous non-profit making
corporate body that prepares accounting,
auditing, governance, ethics and Shari'a
standards for Islamic financial institutions.
AAOIFI was established in accordance with the
Agreement of Association which was signed by
Islamic financial institutions on 1 Safar, 1410H
corresponding to 26 February, 1990 in Algiers.
AAOIFI was registered on 11 Ramadan 1411
corresponding to 27 March, 1991 in the State of
Bahrain.
AAOIFI’S OBJECTIVES & ROLE





Develop accounting, auditing, governance and ethical thought
relating to the activities of Islamic financial institutions taking into
consideration the international standards and practices which comply
with Islamic Shari'a rules.
Disseminate the accounting, auditing, governance and ethical
thoughts relating to the activities of Islamic financial institutions and
its application through training seminars, publication of periodical
newsletters, preparation of reports, research and through other
means.
Harmonize the accounting policies and procedures adopted by Islamic
financial institutions through the preparation and issuance of
accounting standards and the interpretations of the same to the said
institutions.
Improve the quality and uniformity of auditing and governance
practices relating to Islamic financial institutions through the
preparation and issuance of auditing and governance standards and
the interpretation of the same to the said institutions.
Promote good ethical practices relating to Islamic financial
institutions through the preparation and issuance of
STANDARD SETTING APROACHES
AAOIFI adopts the standard setting due process
by reviewing existing Islamic banking reporting
practices followed by formulation of discussion
paper, exposure draft and reporting standard.
 Existing IAS standards are referred to where
these are deemed relevant and not contravening
the Shari’ah Principle.

ACCOUNTING STANDARDS
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
General Presentation and Disclosure in the Financial
Statements of Islamic Banks and Financial Institutions
Murabaha and Murabaha to the Purchase Orderer
Mudaraba Financing
Musharaka Financing
Disclosure of Bases for Profit Allocation between Owners'
Equity and Investment Account Holders and Their
Equivalent
Salam and Parallel Salam
Ijarah and Ijarah Muntahia Bittamleek
Istisna'a and Parallel Istisna'a
Zakah
Provisions and Reserves
General Presentation and Disclosure in Financial
Statements of Islamic Insurance Companies
ACCOUNTING STANDARDS
12.
13.
14.
15.
16.
17.
18.
19.
20.
21.
Disclosure of Bases for Determining and Allocationg
Surplus or Deficit in Islamic Insurance Companies
Investment Funds
Provisions and Reserves in Islamic Insurance Companies
Foreign Currency Transactions and Foreign Operations
Investments
Islamic Financial Services offered by Conventional
Financial Institutions
Contributions in Islamic Insurance Companies (New)
Deferred Payment Sale
Disclosure on Transfer of Assets (New)
Segment Reporting (New)
AUDITING STANDARDS
1.
2.
3.
4.
5.
Objective and Principles of Auditing
The Auditor's Report
Terms of Audit Engagement
Testing by an External Auditor for Compliance
with Shari'a Rules and Principles by an
External Auditor
The Auditor's Responsibility to Consider Fraud
and Error in an Audit to Financial Statements
(New)
GOVERNANCE STANDARDS &
CODE OF ETHICS
Governance Standards
1.
Shari'a Supervisory Board: Appointment,
Composition and Report
2.
Shari'a Review
3.
Internal Shari'a Review
4.
Audit and Governance Committee for Islamic
Financial Institutions
Ethics
1.
Code of Ethics for Accounting and Auditors of
Islamic Financial Institutions
2.
Code of Ethics for the Employees of Islamic
Financial Institutions
NATURE OF FINANCIAL REPORTING
Financial Accounting Statements No. 1 & 2
 Objective of Financial Accounting of
Islamic Banks and Financial Institutions

Emphasizes the importance of contractual
rights and obligations and Shari’ah compliance
 Concepts
of Financial Accounting for
Islamic Banks and Financial Institutions

Addresses the issue of prohibited earnings &
expenditures as well as ensuring reasonable
rates of returns to depositors
FINANCIAL REPORTING OBJECTIVES
Shari’ah compliance
(principles, rules and
opinions)
 Distinguish & disclose
prohibited earnings &
expenditures
 Present entity’s economic
resources and obligations
and related risks
pertaining to its assets
and liabilities

Determine Zakat
obligations of both
depositors and
shareholders
 Estimate cash flows &
related risk of bank’s
financing assets
 Ensuring reasonable
rates of returns to
investors
 Disclose IB’s discharge of
social responsibilities.

DISTINGUISHING FEATURES OF IFI’S
FINANCIAL ACCOUNTING & REPORTING
OBJECTIVES
 Compliance
with the principles and rules
of Shari’a Islamiyyah need to disclosed in
terms of reporting accountability and
decision usefulness
 Different contractual relationships
require reporting requirements for both
equity and asset based funding and
financing contracts which are:



recognition principles
measurement principles
disclosure & presentation principles
ROLE OF FINANCIAL REPORTING
& ACCOUNTING INFORMATION
FINANCIAL
REPORTS
Economic Decision
Usefulness
Relevance
Economic
Agent
Economic
Consequences
Reporting
Accountability
Reliability
Stewardship
function
Representational
Faithfulness
CHARACTERISTICS OF USEFUL INFORMATION
 Economic






Decision Usefulness
Relevant (Timely, Feedback, Predictive)
Reliable (verifiable, faithful representation, neutral)
Cost and Benefit
Comprehensiveness
Wealth maximization
Safety, Liquidity & Profitability of IFI
INFORMATION FOR DECISION
MAKING

Legitimate Decision
 Lawful Transactions


Lawful goods & Services


nature, type and purpose of goods and services
Competitive price & fair value


fulfilling contractual conditions and
requirements
market mechanism and market structures
Equitable Distribution

reasonable rates of returns to shareholders and
depositors
USER GROUPS OF ACCOUNTING
INFORMATION
 Investors
(potential & existing) [Lawful
&Equitable Investments]


Includes Shareholders and Depositors with different
investment horizons
Investors are not only concerned with profits but also its
lawfulness, legality and equity
 Creditors
(potential & existing) [Lawful
Trade Assets]


Creditors exclude debt holders and confined to asset
backed or trade assets.
Not only concerned with default risk but also validity of
contract and lawfulness of the asset.
USER GROUPS OF ACCOUNTING
INFORMATION

Regulators


Shariah Supervisory Boards & Advisory
Council


Governance extends beyond audit committee to the
Shari’ah governance
Customers [Lawful Goods &Services]


Legislation to be enforced should make reference to the
Shari’ah compliance
Customers are concerned about lawful products & facilities
Others

Any party that directly or indirectly make reference to the
financial statement of IFI
IMPACT OF SHARI’AH CONTRACTUAL
CONDITIONS OF TRANSACTIONS ON REPORTING
PROCESS
Shari’ah
Conditions
Reporting
Process
Impact
Existence
Recognition
Valid contracts
Lawful
Recognition
Lawful Activities
Performance
Measurement
Provision for
uncertainty
Deliverable
Recognition
Provision for
uncertainty
Equitable
Distribution
Reasonable rates
of return
Accountable
Presentation/
Disclosure
True and fair view
Distinguishing contractual relationships render a distinct reporting process to
address the lacunae of entity-based reporting
TYPES OF FINANCIAL
STATEMENTS
 Balance
Sheet
 Income Statement
 Statement of Owner’s Equity
 Cash Flow Statement
 Statement of Restricted Investments
 Statement of Sources & Uses of Zakah
 Statement of Sources & Uses of Qard
Fund
ELEMENTS OF FINANCIAL STATEMENTS
BALANCE SHEET
 Assets
Fixed Assets
 Intangible Assets
 Investments
 Financing

Liabilities
 Investment Deposits
 Equities

INCOME STATEMENT
 Gross Income
 Distribution to
Depositors
 Net Jointly Financed
Income
 Fee based Income
 Expenses
 Net Income
SHARIAH GOVERNANCE: BY WHOM? FOR WHOM?
REGULATORS
SC & BNM
SUPERVISION & SHARIAH
ADVISORY COUNCILS
IFI SHARIAH
SUPERVISORY
BOARD & SHARIAH
COMMITEE
INVESTMENT
ACCOUNT HODERS &
SHAREHOLDERS
BOARD OF DIRECTORS
AUDIT & GOVERNANCE
COMMITEE
EXTERNAL
AUDITORS
NATURE OF SHARI’A SUPERVISORY
BOARD


An independent body of specialised jurists in fiqh al
mu’amalat (Islamic Commercial Jurisprudence), that is
entrusted with the duty of directing, reviewing and
supervising the activities of the Islamic Financial
Institution in order to ensure that they are in compliance
with Islamic Shari’a Rules and Principles.
Types of Shari’a Supervision or Advisory?
 Shari’a Product consultants (Advisory capacity)
 Shari’a Supervisory Board/Shariah committee of Islamic
bank (Constitutional Authority & Advisory)
 Shari’a Advisory Council of Bank Negara Malaysia and
Securities Commission (Statutory & Advisory
NATURE OF SHARI’A SUPERVISORY
BOARD

Scope of Supervision
product and system development
 financial reporting and Shari’a opinion
 Approval of Shari’a financial services and products
 Approval of listed securities and investment funds.

DUTIES & RESPONSIBILITIES OF SHARIAH
COMMITTEE
a)
b)
c)
d)
e)
f)
g)
h)
Advise BOD on business operations to be
Shariah compliant
Endorse Shariah Compliance Manual
Endorse & Validate pertinent documents
Assist related parties (such as auditors, legal
counsel, consultants) that seek advice on
Shariah Matters
Advise IFI to seek clarification or endorsement
of unresolved or endorsed by SAC
Provide written Shariah Opinion
Assist SAC on reference for advice
Shall report to the BOD (act as independent
body of IFI)
SHARIAH COMPLIANCE BEHAVIOR
Levels
Activity
Assurance
For Whom
Product
Endorsement
Lawful, Valid,
Equitable
Counter Party
Interest
Transaction
Endorsement
Lawful & Valid
Counter Party
Interest
System
ICS Review
Effective &
Reliable
Management & BOD
Entity
Policy,
Governance &
Opinion
Lawful, Valid,
Reliable &
Equitable
Investors
(Shareholders &
IAH) & Stakeholders
National
Policy
Policy,
Governance &
Regulation
Sound, Stable,
Sustainable &
International
Acceptance
Investors (
Shareholders &
IAH), Stakeholders
& Public Interest
SHARI'AH REVIEW & INTERNAL SHARI’A
REVIEW


Shari’a review is an examination (by SSB) of
the extent of an institution (IFI’s) compliance,
in all its activities, with the Shari’a.
Internal Shari’a review shall be carried out
by an independent division/department or part
of the internal audit department, depending on
the size of an institution (IFI). It shall be
established within the institution to examine
and evaluate the extent of compliance with
Islamic Shari’a rules and principles, fatwas
and guidelines, and instructions issued by the
Institution (IFI) Shari’ah Supervisory Board.
INTERNAL SHARI’A REVIEW
It forms an integral
part of the organs of
governance of the
Institution (IFI) and
operates under the
policies established by
the Institution (IFI).
 Reviewers should not
have any executive
authority or
responsibility for the
activities they review


Integral Elements:




Independence &
Objectivity
(organizational status,
independent attitude &
tasks assigned)
Direct and continuous
communication to all
parties with unlimited
access to required
documents.
Professional Proficiency
(including knowledge
skills and training in
Fiqh al Muamalat)
Due professional Care
SCOPE & ROLE OF INTERNAL SHARI’A
REVIEWER



Scope: To examine and evaluate the adequacy and
effectiveness of the institution system of internal
Shari’a control and the quality of performance in
carrying out assigned responsibilities.
Purpose: To ascertain whether the system provides
reasonable assurance that objectives set out are
complied in an effective and efficient manner.
Internal Shari’a Review Work involves planning
(include: establishing shari’ah review objectives,
obtaining and making reference to fatwas, guidelines,
Shari’a review results, writing internal Shari’ah
review programs, communicating the procedures as
well as results to parties concerns)
AUDITOR & SSB RELATIONSHIP
Auditor complements SSB of Islamic banks
 ASIFI No. 1 is to enable the auditor to express an
opinion as to whether the financial statements
are prepared, in all material aspects, in
accordance with Shari'ah Rules & Principles,
AAOIFI & International accounting standards

AUDIT REPORT & SHARI’A OPINION
Independent samples and tests conducted by both
auditor and SSB
Audit opinion
 the financial statements as a whole are free from
material misstatement based on accumulated
audit evidence, refers to the whole audit process
and comply with Islamic Shari'a Rules and
Principles

AUDIT REPORT & SHARI’A OPINION

Shari’a Opinion will be on matters pertaining to:
contracts, transactions and dealings
 equitable allocation of profit & losses
 earnings (lawful/prohibited)
 Zakah …

AUDIT & GOVERNANCE COMMITTEE
AGC is to assist in achieving institutions
objectives by enhancing greater transparency and
disclosure as well as public confidence on
institutions application of Shari’a rules and
principles.
 Comprise of non-executive directors with sound
understanding of the business and Shari’a
supervision

AUDIT & GOVERNANCE COMMITTEE
ROLE & FUNCTIONS
Preserving integrity of
financial reporting
process
 Safeguarding
interests of investors
and stakeholders
 Assurance on
financial information
reliability
 Link between
management and
stakeholders

Review of internal
controls
 Review of Accounting
practices and audit
plan
 Review of interim and
annual accounts and
financial reports
 Review of compliance
with Shari’a rules and
principles

REPORTING & COMMUNICATION CHANNELS
Audit & Governance Committee
Express
Shariah
Opinion on IFI
True & Fair
Opinion
Shariah
Board/Shariah
Committee
Internal Audit
External Auditor
Formulate
Policy
ATTEST
Testing for Shariah
Compliance
Shariah
Endorsement
Shariah Review
Islamic Financial
Institution
INTERNAL
CONTROL
SYSTEM
Internal Shariah
Review
ISLAMIC FINANCIAL SERVICES BOARD
(IFSB)
 The
Islamic Financial Services Board
(IFSB) , based in Kuala Lumpur,
inaugurated on 3rd November 2002 and
commenced on 10th March 2003
 It serves as an international-standard
setting body of regulatory and supervisory
agencies that have vested interest in
ensuring the soundness and stability of
the Islamic financial services industry
(banking, capital market and insurance).
IFSB : PURPOSE & ROLE
 IFSB
promotes the development of a
prudent and transparent Islamic financial
services industry through introducing
new, or adapting existing international
standards consistent with Islamic
Shari'ah principles, and recommend them
for adoption.
 IFSB complements that of the Basel
Committee on Banking Supervision,
International Organization of Securities
Commissions and the International
Association of Insurance Supervisors
IFSB STANDARD, GUIDELINES &
PRINCIPLES
GUIDING
PRINCIPLES OF
RISK
MANAGEMENT
GUIDING
PRINCIPLES ON
CORPORATE
GOVERNANCE
INSTITUTIONS
OFFERING
ISLAMIC
FINANCIAL
SERVICES (IFSI)
CAPITAL
ADEQUACY
STANDARDS
DISCLOSURE
PRINCIPLES TO
PROMOTE
TRANSPARENC
Y & MARKET
DISCIPLINE
GUIDANCE ON
KEY ELEMENTS
–
SUPERVISORY
REVIEW
PROCESS
IFSB STANDARDS
Guiding Principles on Risk Management
 Capital Adequacy Standard
 Guiding Principles on Corporate Governance
 Disclosure Principles to Promote Transparency
and Market Discipline
 Guidance on Key Elements – Supervisory Review
Process

UNIQUE RISKS OF ISLAMIC FINANCIAL
INSTITUTIONS
Rate of return risk relates to market factors
affecting rate of return on assets in comparison
with rate of return for investment account
holders
 Displaced commercial risk relates to market
factors affecting rate of return on assets in
comparison with rate of return for Shareholders
 Equity investment risk relates to risk
characteristics of equity investments in the form
of Mudaraba and Musharaka (including
transformation of risks at various stages of
investment life cycle)
 Operational risk in the form of fiduciary risk that
relates to Shariah non-compliance

Anatomy of Asset Risk Exposures
Financing Type
Contract Type
Risk Exposure
Credit Risk
Sales type
Murabaha
Bai Muajjal
Salam
Istisna’a
Non-delivery &
Credit Risk
Equity
Mudaraba
Musharaka
Credit/Market risk
Equity investment
Risk
Leasing
Ijarah
Ijarah Muntahia
Biltamleek
Market risk
Credit risk
Financing or Investment?
INCOME DISTRIBUTION TO PER, IRR, SHF &
IAH
Income Attributable to IAH
Less: Transfer of
Profits to SHF PER
Income distributed
to Shareholders &
Investment
Account Holders
Based on PSR
Income
Distributabl
e to IAH
Income
Attributable to
SHF & Other
Deposit funds
Return on
Equity
Less: Transfer of
Profits to IAH PER
Less: Transfer of
Profits to IAH IRR
Return on
Unrestricted IAH
ANATOMY OF FUNDING RISK EXPOSURES
Source of
Funds
Risk Exposures
Guarantee/
Reserves
Deposits
Liquidity risk
Deposit Guarantee
Unrestricted
Investment
accounts
Liquidity risk
Rate of return
risk
ROA vis-à-vis ROUIAH
Profit Equalization Reserve
Investment Risk Reserve
Shareholders
Funds
Displaced
Commercial Risk
Solvency Risk
ROA vis-à-vis ROE
Profit Equalization Reserve
Restricted
Investment
Accounts
Rate of return
risk
Profit Equalization Reserve
Investment Risk Reserve
ILLUSTRATION OF IFSB CAR
(STANDARD FORMULA)
CAR =
Eligible Capital
{Total Risk-Weighted Assets (Credit* + Market*
Risks) Plus Operational Risks
less
Risk Weighted Assets funded by PSIA**(Credit * +
Market * Risks)
* Credit and Market risk for on and off balance sheet
exposures
** PSIA balances include PER and IRR
FINANCIAL REPORTING, AUDITING &
GOVERNANCE FRAMEWORK
SHAREHOLDERS
INVESTMENT
ACCOUNT
HOLDERS
OTHER
STAKEHOLDERS
AAOIFI
IFSB
ISLAMIC
FINANCIAL
INSTITUTION
REGULATORY
AUTHORITIES
AUDIT
COMMITTEE
SHARI’AH
SUPERVISORY
BOARD
GOVERNANCE
COMITTEE
ROLE OF SHARIAH REVIEW, AUDIT &
GOVERNANCE
Financial,
Statements,
Reports
and other
Useful
Information
Required by
AAOIFI &
Relevant
International
Financial
Reporting,
Auditing &
Governance
Standards
Shari’ah Goals, Opinions & Rulings
Propounded by Shari’ah Scholars
SHARIAH
COMPLIANCE
BEHAVIOR
Prudential
Guidelines
& Standards
Promulgated
By IFSB to
Ensure
Risk
Management &
Disclosure
Framework
Related to
Capital
Adequacy,
Corporate
Governance &
Market Discipline
Regulatory requirements by Central Banks,
Monetary Authorities or Supervisory Agencies
SHARIAH GOVERNANCE ASSURANCE FRAMEWORK
SC & BNM SAC
SC & BNM Supervisory
Review
SHARIAH SUPERVISORY
BOARDS & SHARIAH
COMMITTEE
Promulgate National
Shariah Rulings,
Opinions & Policies
Shariah rulngs &
basis
Approved Products
& Services
Conduct supervision of
IFI on Shariah
compliance
Specific Guidelines
& Reports on
Shariah
compliance
Formulate and review IFI
Shariah opinions and
policies
Comprehensive
Shariah
Supervisory Report
EXTERNAL AUDITORS
Undertake financial
audit to express true
and fair opinion
External Audit
report
BOARD OF DIRECTORS
AUDIT & GOVERNANCE
COMMITTEE
Structure, internal control
processes and activities
of IFI are Shariah
Compliant
Statement of
Corporate
Governance
THANK YOU & WASSALAM